Action Now = Tax Savings in April

I keep hearing that I should do something or other to improve my tax situation before the year ends. Is there really anything I can do at this point?

Whether you are having a good year, rebounding from recent losses, or still struggling to get off the ground, you may be able to save a bundle on your taxes if you make the right moves before the end of the year.

December 31 is the key date because that’s when the IRS pretty much closes the books for 2008. Actions you take before then count when you prepare your 2008 tax return next spring. Come New Year’s Day, most money-saving moves you make won’t pay off until 2010, when you file your 2009 income tax return. But be careful. Some easy-to-follow advice that you read in the papers, hear on TV or read on the Internet can backfire.

Before you do anything, consider making income tax projections for this year and next (at least). If your situation is complicated enough, you will need a software program like TurboTax… Once you have the numbers, however, you can see how any actions you take will affect your tax bill each year. With that information in hand, these tips can help you hang onto your cash.

-Defer income

-Exploit last-minute deductions

-Beware of the Alternative Minimum Tax

-Sell loser stocks to offset gains

-Do a bond swap

-Don’t buy a tax bill

-Contribute the maximum to retirement accounts

-Avoid the kiddie tax

-Check IRA distributions

-Watch your flexible spending accounts

1. Defer Income

The theory here is simple: Income you don’t receive until after midnight on New Year’s Eve isn’t taxed until the following year. Even if you’ll be in the same tax bracket, you win by putting off the tax bill. It’s tough for employees to postpone wage and salary income. You can’t ask your employer to hold your December pay until January; nor do you push income into the next year by not cashing your check until then. Income is taxable in the year it is “constructively received.” Basically, that means the year you could have had the money if you wanted it. Say, for example, that in December your boss offers you a choice of receiving a Christmas bonus in December or January. Regardless of which you choose, the IRS will expect you to report and pay tax on the income with your return for the year the offer was made. If standard practice in your company is to pay year-end bonuses the following year, however, the income would be taxed in the year you get the check.

If you are self-employed or do freelance or consulting work, you have more leeway. Delaying billings until late December, for example, can assure that you won’t receive payment until the next year. If you are pressing for payment on an overdue account, it might make sense to give your client a short breather. If you own rental property, you may want to be generous and suggest to your tenants you wouldn’t mind if the December rent check didn’t arrive until January. Business considerations certainly come first. But if it’s unlikely you have anything to lose by holding off on collections, doing so can push some taxable income — and the tax bill on it — into the following year.

Of course, it only makes sense to defer income if you think you will be in the same or lower tax bracket next year. You don’t want to be hit with a bigger tax bill next year if an extra chunk of income could push you into a higher income tax bracket. If that’s likely, in fact, you may want to accelerate income into 2008 so you can pay tax on it in a lower bracket sooner, rather than in a higher bracket later.

2. Exploit Last-Minute Deductions

Contributing to charity is a noble way to get a deduction. And you control the timing. Sometimes, though, it’s best to put away your checkbook. You can supercharge the tax benefits of your generosity by donating appreciated stock or property rather than cash. As long as you’ve owned the asset for more than one year, you get a double tax benefit from the donation: You can deduct the market value on the date of the gift and you avoid forever paying capital gains tax on the appreciation that built up while you owned the asset. The charity you’re interested in helping can help you with the details.
Note that you must have either a receipt or a canceled check to back up any contribution, regardless of the amount. If you don’t have such a written record, the IRS will reject the write-off if the lack of proper record keeping is discovered in an audit. (The old rule that you only had to have a receipt to back up contributions of $250 or more is long gone.)

Accelerating payment of deductible expenses due in January can pull the write-offs into 2008. This could apply to an estimated state income tax bill due January 15, for example, or a property tax bill due early in the next year. Or a doctors or hospital bill. (But speeding up deductions could be a blunder if you’re subject to the Alternative Minimum Tax, as discussed below.)

Before you go into high gear racking up deductions, make sure you’ll be itemizing for 2008 rather than claiming the standard deduction. Unless the total of your qualifying expenses exceeds $5,450, if single, or $10,900 if you’re married and will file a joint return, itemizing would be a mistake. Single filers who pay property taxes, can add up to another $500 to their threshold and joint filers can add up to $1,000 of real estate tax payments to their threshold. If you are on the itemize-or-not borderline, your year-end strategy should focus on bunching. This is the practice of timing expenses to produce lean and fat years. In one year, you cram in as many deductible expenses as possible, using the tactics outlined above. The goal is to surpass the standard-deduction amount and claim a larger write-off. In alternating years, you skimp on deductible expenses to hold them below the standard deduction amount – because you get credit for the full standard deduction regardless of how much you actually spend. In the lean years, year-end plans stress pushing as many deductible expenses as possible into the following fat year when they’ll have some value.